The Federal Reserve Extends Operation Twist - June 20, 2012

The Federal Reserve, earlier this afternoon, announced that it was extending a program that is designed to drive down longer-dated Treasury yields in the hope of spurring additional economic activity. This program, known as Operation Twist, basically involves the central bank's selling of shorter-term bonds and buying longer-dated issues.

The move was a middle ground approach, between just staying the course and adopting a more aggressive approach, popularly known as quantitative easing. Twice prior to this time, the Fed had adopted such efforts, with Wall Street dubbing them QE1 and QE2. Some had speculated that the just-concluded two-day FOMC meeting would have produced a so-called QE3 program. We had felt the extension of Operation Twist was the more likely outcome. We think this is a reasonable approach, but expect only limited help from it.

The Fed also intoned that it would keep short-term interest rates (e.g., the federal funds target) at their present record low levels until at least the end of 2014. Unless U.S. business activity firms sufficiently in the interim, we sense that the lead bank could even extend that date down the road.

The Fed is acting now because hiring has weakened; GDP growth expectations have come down; and the economy, under pressure from the evolving recession encompassing much of the euro zone, is just too fragile for the status quo. Specifically, the central bank said it will retain Operation Twist until the end of this year and, then, presumably examine the program once again. The Fed clearly hopes that this move will spur additional borrowing by reducing long-term rates even more.

However, that may well be wishful thinking, as those contemplating a home purchase, for example, while logically cheered by the potential for still-lower mortgage rates, might not act on this incentive if they fear for their jobs and income. Thus, as one noted economist observed “This move is largely symbolic.” On the other hand, many traders will undoubtedly be mollified by the suggestion that the Fed stands ready to do even more if conditions deteriorate in the months to come. The probable catalyst for such a possible deterioration would appear, at least at this time, to be Europe, where several nations are under mounting economic pressure, as the euro zone tries to keep itself relevant and intact. Rising bond yields in Spain and Italy, for instance, are an outgrowth of the economic and financial deterioration across the Continent.

Finally, the Fed felt it could act at this time due to the recent drop in oil prices to near $80 a barrel in New York, and the reassuring news on inflation issued over the past week on both the producer and consumer prices.

As to the Fed's reaction to recent events, the central bank, in its accompanying statement, suggests anew that the economy has been expanding moderately this year, but that employment and unemployment problems linger.

At the time of this article, the writer did not have positions in any of the companies mentioned.